Observing consolidation behavior aids prediction

09:17, October 25, 2010      

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Markets do not move up dramatically for extended periods. A pullback is inevitable and it's the nature of the pullback that defines the sustainability of the underlying trend. This is a significant question that applies to the Shanghai index after the powerful breakout from the resistance level near 2700.

The nature of the consolidation behavior in the Shanghai index provides some of the answers to the potential for the pullback and development of the future trend.

The most significant risk in a very fast market rise is that it is followed by a very fast fall, often taking away 70 to 80 percent of the original rise. When the fast rise develops a parabolic trend, as seen in the Dollar Index in early 2010, then the fast fall is an almost inevitable outcome. The fast rise in the Shanghai index is not a parabolic trend. It's more like taking a fast elevator from one floor to the next. The Shanghai Index floors are created by two historical consolidation areas.

Trading consolidation bands provides an effective way to assess potential breakout targets. The width of the trading band is measured and projected upwards or downwards to set the target level. Is this effective? These trading band breakouts and targets are applied to the analysis of the Korean KOSPI, the Hang Seng, the Indian Nifty and Sensex indexes and to many other markets. The calculation method provides reliable analysis that goes beyond a coincidental relationship. This is correlated behavior, repeated across many different markets and stocks.

Observing the behavior is one step, but explaining why this relationship exists is more difficult. For investors and traders the "Why?" is less important than the fact. Although we can develop our preferred explanation for this behavior, the reality is that we cannot really explain it. This does not prevent investors from making good use of the repeated behavior and applying it to the analysis of the current Shanghai index breakout.

There are two powerful trading band consolidation areas in the Shanghai index. Starting in October 2009 and ending in April 2010, the Shanghai index moves in a broad sideways trading band. Support was near 2950. Resistance was near 3330. This is consolidation area 1.

Trading consolidation bands provide a foundation for the next trend breakout. The width of the trading band is measured and this value is used to calculate upside and downside targets.

The index broke below this trading band in April. It quickly achieved the calculated downside target of 2550. It moved below this target level and then developed an inverted head and shoulder pattern. The breakout from the inverted head and shoulder pattern also developed a more recent trading and consolidation pattern.

This lower sideways consolidation pattern has support near 2580. Resistance was near 2700. This is consolidation area 2. The width of the pattern is used to calculate the upside breakout targets. The first target calculation was at 2800. This target was quickly achieved when the index breakout developed on Oct 8. The second breakout target is calculated by doubling the width of the original trading consolidation band. This gives a target level near 2950 and this was also achieved.

The current breakout is consistent with the trading band breakout calculation targets. The most bullish result is when the Shanghai index continues to use 2950 as a support level. This signals the market will move towards the upside levels of consolidation area 1 near 3330. There is a high probability of a long term consolidation between 2950 and 3330 continuing for several months. The key evidence of this is the ability of 2950 to act as a strong support level.

Failure of support at 2950 sets a short-term downside target near 2800. This calculation uses the width of the lower consolidation area 2. The longer-term downside target is calculated using the width of the original upper consolidation area 1 trading band between 2950 and 3330. This gives a downside target near 2550. In the next few weeks it is important to watch for the strength of support near 2950.

The author is a well-known international financial technical analysis expert.

Source: China Daily (By Daryl Guppy )


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